Apparently, USAirways (the recently merged product of America West and US Air) has made a bid for buying Delta out of bankruptcy. The bid is around $4 billion in cash and $4 billion in USAirways stock. Which got me thinking about airline mergers in general.

Companies can be thought of as having tangible assets (trucks, airplanes, factories) and intangible assets (reputation, employees, brand names, contracts). Most companies are worth far more than the book value of their tangible assets. Most of Microsoft's value, for example, is in it's products, its brand, its franchise, its contracts, its people, etc., not in hardware or buildings. As a result, most acquisitions are completed at prices far above the book value of the assets of the purchased company. The difference is called "goodwill" by accountants and "enterprise value" by economists.

But enterprise value is a problem in airline mergers. Most investors expect to pay and get paid a premium over asset values in a merger. But I am not sure there should be any such premium nowadays for airlines, because I fear that the typical airline's "goodwill", or the value of their intangible assets, may be negative.

Take the example of Delta. Unlike scrappy competitors like Southwest and JetBlue, Delta has a lot of baggage (so to speak). First and foremost, they have terrible legacy union contracts that mean that pay all of their employees much more money than do startup airlines and they are much more constrained by work rules in improving productivity. They have huge and building under-funded retirement and medical accounts. They have legacy contracts that may suck, and they often have hodge-podge mixed fleets that are hard to maintain. All of this tends to add up to a negative effect on value.

The one positive intangible companies like Delta have is their brand value, and I would argue that most of that is tied up in their frequent flier programs[** Update Below]. Without these programs, most frequent fliers have demonstrated that they would switch airlines for trivial improvements in fares. This value in the frequent flier programs was demonstrated in the America West merger (among others), when Juniper Bank contributed $455 million (!) to the merger for the right to issue the visa card attached to the program. Wow.

Given this problem of negative enterprise value, it is not surprising that savvy upstarts like JetBlue and Southwest before it have not grown by acquiring other companies. Both are willing to take advantage of bankrupt competitors to grow, but they only have bought assets (like planes and gates) rather than whole enterprises, so they don't inherit legacy contract or union issues. When the companies who are making money do things one way, and the companies who find themselves in bankruptcy court every five years do it another way, the difference probably matters.

Which brings me to the title of the post and agency costs. It is really, really uncertain whether buying Delta is good for the USAirways shareholders. Since buying airline equities has always been a losing proposition over the long haul, the deal only makes sense if 1) They are getting a screaming deal, either because of Delta's bankruptcy or because they are doing the deal in just the right part of the business cycle; or 2) They can really harvest synergies, which in this case would have to include shutting down entire hubs, such as Charlotte in favor of Atlanta or Cincinnati in favor of Pittsburgh. While I can't speak to the latter with any facts, you have a better chance betting Arizona will win the Superbowl than betting any acquisition hits its promised synergy values.

But if the value of the acquisition is unclear for shareholders, there is one group that almost certainly benefits: USAirways management. Management, even if shareholders don't get a great deal, will benefit in both monetary and non-monetary (e.g. status) ways from running an airline three or four times as large as the current enterprise. This mis-match in incentives between hired management and shareholders is called agency costs, and is something every board should be more cognizant of when approving acquisitions.